The author is a Forbes contributor. The opinions expressed are those of the writer.

Loading ...

Loading ...

This story appears in the {{article.article.magazine.pretty_date}} issue of {{article.article.magazine.pubName}}. Subscribe

The financial industry would prefer you to believe that you can’t be a successful investor without it. That’s good for business but it’s not exactly true.

In fact, it may be truer to suggest that a layperson with a reasonable grasp of middle school math—combined with the rarer traits of discipline, grit and humility—is capable of building a portfolio that could beat the majority of professional stock pickers over the long-term.

Please note I’m not suggesting that most individual investors are likely to beat the pros. Indeed, statistics suggest just the opposite, as individual investors regularly underperform the very investments—mutual funds, run by professionals—that they own.

But the vast majority of professional money managers actively attempting to beat their respective benchmarks also have demonstrated a persistent propensity to underperform. In other words, they don’t “beat the market.” Therefore, the individual willing and able to effectively capture market returns should indeed beat the pros. It is surprisingly simple, but it is not easy.

So, just “buy the market,” then? Perhaps, but which one?

The S&P 500, the benchmark of benchmarks, tracks the 500 largest publicly traded U.S. companies. It’s “the market,” although not an investment in and of itself, and it’s the bogey that most stock fund managers are chasing. Since 1927, the index has earned an annualized return of 10.1% with an annualized standard deviation of 20.2%.

The annualized return gives you an idea of how much you’d have earned per year over that stretch. But it wasn’t as smooth a ride as any of us would prefer, as evidenced by the second figure. The annualized standard deviation is a more intimidating statistic, but you don’t need to fully understand in order to grasp its importance. In short, it’s a measurement of volatility or risk, the degree to which an investment would have deviated from its average return over a given timeframe.

An investor certainly could buy an index mutual fund or exchange-traded fund designed to mimic the S&P 500 and call it a day. Doing so, however, would likely expose that investor to more risk—and interestingly, less return—than might otherwise be optimal. Let’s use the S&P 500 as a starting point, and then build a DIY portfolio from there in three steps.

1927-2014

Annualized Return

Annual Standard Deviation

S&P 500

10.1%

20.2%

Step 1: Add fixed income to lower portfolio volatility.

The market was good to the patient investor between 1927 and 2014. $10,000 invested at the beginning of that period would have grown to nearly $47.6 million. But most could not have weathered the volatility associated with that investment along the way. The worst single year was down 43%, and the worst three-year stretch resulted in a 61% decline.

The antidote to stock volatility is fixed income, or bonds. We invest in stocks to make money, but we invest in bonds to keep us invested in stocks when volatility threatens to derail us from our long-term financial plan. Yes, a well-diversified, all-stock portfolio should certainly earn more than a balanced portfolio over your lifetime. But if you abandon your portfolio due to high volatility in the worst of times, it’s all for naught.

And since the primary purpose of investing in bonds is to stabilize a portfolio and keep us invested in stocks, consider purchasing only the stable-est of the stable, such as U.S Treasuries or FDIC-insured CDs. For our purposes, we’ll take 40% of our previous allocation to large-cap stocks and invest it in five-year U.S. Treasuries. Here’s what happens:

Portfolio 1:

60% - S&P 500 Index

40% - 5-Year Treasuries

1927-2014

Annualized Return

Annual Standard Deviation

S&P 500

10.1%

20.2%

Portfolio 1

8.7%

12.3%

What’s most interesting to me about the change in the numbers from the S&P 500-only investment to the results we see from Portfolio 1 is that our measurement of risk drops a relative 39.1%, proportionately far more than our return, which falls a relative 13.8%. But what if large U.S. company stocks weren’t the only equities in which we invested? How might the complexion of this portfolio change further?

Step 2: Add small company stocks, to increase return.

Small company stocks historically have provided higher returns than large company stocks. That probably doesn’t come as a surprise, right? Smaller companies are hungrier, nimbler and have more room to grow. But it also probably doesn’t come as a surprise that they are riskier and less predictable. Let’s see what the portfolio looks like if we take half of the allocation we’ve dedicated to large companies and devote it to small companies. In order to do so, we’re relying on the research of Nobel prize-winning economist, Eugene Fama, and his colleague, Kenneth French.

Portfolio 2

30% - S&P 500 Index

30% - Fama/French US Small Cap Index

40% - 5 Year Treasuries

1927-2014

Annualized Return

Annual Standard Deviation

S&P 500

10.1%

20.2%

Portfolio 1

8.7%

12.3%

Portfolio 2

9.6%

14.6%

Step 3: Add undervalued company stocks, to further increase returns.

Fama and French are credited with the “three-factor model” of investing. Instead of relying on hunches and predictions, they ran the numbers and found statistical evidence that stocks return more than bonds, small companies return more than larger companies and, furthermore, that undervalued—or value—companies return more than growth companies.

This sounds counterintuitive, because the word “growth” looks more dynamic. Value companies, however, are firms whose stock price has been beaten down relative to the company's earnings or "book value," ironically giving them more room to grow than growth stocks. These “distressed” companies, of course, also come with a catch—increased risk and higher volatility. Still, by adding this third “factor” to our portfolio, we arrive at one that has for the past 88 years posted the same rate of return as the all-stock S&P 500, and that with 20.7% less relative volatility.

Portfolio 3

15% - S&P 500 Index

15% - Fama/French US Large Value

15% - Fama/French US Small Cap Index

15% - Fama/French US Small Value

40% - 5 Year Treasuries

1927-2014

Annualized Return

Annual Standard Deviation

S&P 500

10.1%

20.2%

Portfolio 1

8.7%

12.3%

Portfolio 2

9.6%

14.6%

Portfolio 3

10.1%

16%

The “three factors” I’ve mentioned aren’t the only ones to be considered in portfolio construction, but they are the most influential. An additional consideration is the introduction of international stocks. Besides seeming like a generally good idea to consider the economic output of the other 95% of the Earth’s seven billion inhabitants and about half the world’s market capitalization of stocks, international stocks also diversify the economic and geopolitical risks of investing in only the U.S.

The Simple Money Portfolio

This brings us to the Simple Money Portfolio (so named because it is the central focus of the investing guidance in my forthcoming personal finance book, Simple Money). Using the analysis above, it translates the various appropriate indices (in which you can’t actually invest) into those in which you can:

How, you should ask, can a simple, index-based portfolio outperform most professional investors while taking less risk?

It diversifies the stock-based investments across a broad range of asset classes that historically have rewarded investors with higher returns than the broader market (small cap stocks and value stocks).

It diversifies half of the stock exposure beyond the U.S. and Canada into the international landscape. This exposes the portfolio to many opportunities beyond our borders.

It lowers overall risk by investing 40 percent of the portfolio in fixed-income instruments, like bonds.

It limits the negative impact of riskier fixed-income implements by only investing in the most conservative bonds (or bond equivalents) available.

Modifications

This is a moderate portfolio, one that for many investors may appear too cautious with 40% allocated to decidedly conservative fixed income. There is a reason for this: Behavioral science has taught us that losing hurts more than winning helps. In fact, we tend to feel the pain of a decline twice as hard as the joy we experience when everything is on the rise. In essence, we’re more conservative than we think, and therefore would do well to err on the side of conservatism in portfolio construction. Please note that the equity, or stock, allocations in this portfolio are, in and of themselves, more volatile than the U.S. large cap market alone.

But it may be entirely appropriate to adjust your allocation to better suit your ability, willingness and need to take risk. This can be easily done by calibrating the stock-to-bond ratio to reflect a more aggressive or conservative posture while maintaining the relative ratios between the equity asset classes.

Some investors may also be concerned about having 50% of their stock exposure allocated to international companies. I understand this concern, in part because I share it. I don’t understand languages, cultures, economies and markets around the world in the same way that I do in my home country—but I recognize this as a personal bias, not necessarily reflective of the data. Nonetheless, if you feel overexposed internationally, reduce the internationally oriented stock ratio from 50% to 40% or even 25%, but I encourage you not to eliminate it entirely.

Ongoing Maintenance

Is this a set-it-and-forget-it portfolio? No, I don’t want you to be an active trader of your investments, but I do advocate for active ownership. That means rebalancing periodically, bringing your portfolio back to its intended allocation as certain slices of the pie inevitably shrink and swell. This should, over time, actually reduce overall portfolio volatility.

While rebalancing doesn’t always feel safe—taking from the parts of your portfolio that have done well and giving to those that have underperformed—the practice is entirely logical and helps ensure that you are consistently buying relatively low and selling high. Most 401(k)s and other employer-sponsored retirement plans make this an easy, automated process that you can elect when you put your portfolio in place.

Implementation

It will take some work to translate what you’ve read above to your individual situation. Your 401(k) likely only has so many options, so I recommend you try to match up the indices I’ve referenced with the most applicable index fund you can find. If index funds aren’t available to you, look for an equivalent fund that has the lowest expense ratio possible.

If you’re investing outside of an employer-sponsored retirement plan, you may consider utilizing ETFs—exchange-traded funds—although I do caution you that these instruments are often more complex than they initially appear. You could do much worse than to simply build your DIY portfolio with funds from , through whom you’ll find access to each of the indices mentioned in the Simple Money Portfolio.

A Word of Caution

I urge you not to take this on unless you have the discipline and grit to build and maintain the portfolio, and the humility to submit yourself to the evidence. The evidence suggests that most investors do not, or would prefer to apply their effort to endeavors more to their liking. I believe, however, that education could inspire the confidence to apply investing discipline, and that the higher allocation to fixed income helps investors to stay the course.

But what about humility? This is where the financial industry fails. The industry has discipline and grit—but its lack of humility has been its undoing. Even though the vast majority of stock pickers don’t beat the market, every stock picker, by definition, thinks he or she can. This is precisely the reason that a dedicated DIY investor can actually beat the majority of pros.

What about having a financial advisor?

Does this mean that there’s no place, or need, for a financial advisor? Hardly. Many, if not most, investors simply feel more comfortable with the guidance of a dedicated professional whose life’s work is to marinate in this stuff. And even though you may have the discipline and the humility to establish a great DIY portfolio, many fewer investors have the grit to survive the most tumultuous market times.

Additionally, a true financial advisor is not solely an investment advisor. This is an important distinction, because a good advisor will help you place your investment strategy within the context of your cash flow, insurance, tax, education, retirement and estate planning. The Certified Financial Planner™ Board has been one of the industry’s foremost advocates in promoting holistic, comprehensive financial planning, and the CFP® credential, while not sufficient, is a good sign that your advisor has the training to view your money within the context of your life.

But the best financial advisor will ensure that all of this financial planning is built on the foundation of your personal priorities and goals. This is imperative because personal finance is more personal than it is finance. In the end, behavior management is more important than financial management. And that’s one critical reason why this financial advisor makes sure to have his own financial advisor.

Historical return data supplied by Dimensional Fund Advisors. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. return includes reinvestment of dividends. Annualized from quarterly data. All portfolios rebalanced quarterly.